Tuesday, July 8, 2014

When Interest Rates Rise?

Since the financial crash of 2008, one of the biggest guessing games in the U.S. economy and markets has centered on interest rates — and when they would finally rise from the historic lows that followed the Great Recession.

But year after year, analysts who predicted a sustained rebound in rates have been foiled. The long stretch of rock-bottom rates has been great for many home buyers, corporate borrowers and stock markets. It has been murder on conservative savers, particularly older people with money in banks.

Now, with the U.S. economy showing resilience after a winter slump, the focus has again shifted to the question of when interest rates could begin to return to "normal" levels.

Yet many economists and investment pros believe that neither short-term nor long-term rates will go significantly higher, and stay there, in the next few years. More likely, they say, are modest increases that might even be quickly reversed.

The implications of another extended period of depressed rates would be huge for Americans' investing and saving strategies. It could continue to support stocks' bull market and home prices, for example.

But pension funds hoping for higher bond yields to fund promised retiree benefits would be stymied. And there would be more frustration for savers who now have nearly $10 trillion sitting in short-term bank accounts and money market mutual funds, earning almost nothing.

At the heart of the debate, of course, is the Federal Reserve. The nation's central bank controls short-term rates and has held them near zero since the end of 2008 to support the financial system and economy.

In a report Fed policymakers issued after their June meeting, they made clear that they expected to finally begin lifting their benchmark rate in 2015, if the economy continues to expand and unemployment continues to decline.

Even so, 12 of the 16 members of the policy committee expected the Fed's rate to be no higher than 1.5% by the end of 2015 — a full 18 months from now.

Asked for their rate prediction for the end of 2016, the majority of the Fed panel expected 2.5% or less. And because the Fed's rate influences all other interest costs, that would suggest still-low rates across the board.

To put the 2.5% forecast in context, the Fed's key rate was more than double that, at 5.25%, in September 2007, one year before the financial system meltdown.

The Fed's caution fits with a theme that has been heavily debated on Wall Street since 2008: the idea that the U.S. economy, badly scarred by the Great Recession, has become stuck in a slow-growth mode that could last many years.

Lawrence Summers, president emeritus of Harvard University and President Obama's economic advisor in 2009-10, has warned of "secular stagnation," the risk of the U.S. falling into a Japan-style funk marked by weak consumer spending, anemic economic growth, minimal inflation and low interest rates.

Summers' scenario is a more dire version of the "new normal" that investment giant Pimco in Newport Beach described beginning in 2009. The firm, led by bond guru Bill Gross, foresaw a long period of struggle for the debt-saddled global economy instead of the usual rapid post-recession rebound in growth.

Pimco was mostly on target. The U.S. economy grew at an average annual rate of just 2.3% from 2010 through 2013, compared with an annual average of 3.7% from the 1950s through the 1990s (click on image below).

Now, Pimco and Gross have coined a fresh term for what they see ahead: the "New Neutral," a reference to the Fed interest rate level appropriate for the economy's pace and the level of inflation. They see the Fed's rate no higher than 2% through the end of the decade.

"The New Neutral ... suggests things are just gonna be this way for at least the next three to five years, and likely much more," Gross says.

Another huge money manager, Prudential Investment Management, also is warning clients against counting on a return to interest rates that were considered normal seven years ago — let alone to the double-digit rates of the inflation-wracked 1970s.

"People who are looking for higher inflation and higher interest rates are fighting the last war," said Robert Tipp, Prudential's chief investment strategist for fixed income in Newark, N.J.

Rather than a historical oddity, the current low-rate environment is closer to the long-term norm, Tipp said. The 10-year U.S. Treasury note yield, a benchmark for other long-term interest rates including mortgage rates, has mostly bounced between 1.5% and 4% since 2008 (click on image below).

That also was the usual range for the T-note yield from the late 1880s through the early 1960s, a period that included economic booms and busts, according to data compiled by Yale University Professor Robert Shiller.

Even if Fed policymakers begin raising their key rate next year, they will be wary of any new wobble in the economy, Tipp said. "If they see any sign of a slowdown, they'll stop," he said.

That could mean wider intervals between rate hikes, because this economic recovery has had a stop-and-go pattern since it began in mid-2009.

Scott Minerd, chief investment officer at money manager Guggenheim Partners in Santa Monica, also believes the Fed will be "hypersensitive" to economic conditions as it tightens credit. After the economy's crash in 2008-09, "they are frightened that it could ever happen again," he said.

What's more, the Fed's counterparts, the European Central Bank and the Bank of Japan, have shown no signs of retreating from their own campaigns to keep interest rates depressed. Their benchmark short-term rates are even closer to zero than the Fed's rate. And the ECB last week said it was ready to launch new programs to pump money into the struggling Eurozone economy, where the jobless rate is 11.6%, nearly double the U.S. rate of 6.1%.

"The world has become addicted to low interest rates," Minerd said.

But central banks directly control only short-term rates. Long-term rates, such as on bonds, are influenced by the banks but are set by investor demand — from giant pension funds to small savers hunting for steady income.

This year, once again, investors have been following the central banks' lead by driving bond yields lower. Yields fall when investors are aggressive buyers of bonds because strong demand allows bond issuers to lower the interest rates they offer.

The 10-year T-note has fallen from 3% at the start of 2014 to 2.64% now. That slide took many Wall Street pros by surprise because it came even as the Fed has cut back on its own bond purchases.

In December 2012, the Fed began buying $85 billion a month in Treasury and mortgage bonds, its third round of bond purchases since 2008. The goal of the programs, known as quantitative easing, was to help push long-term interest rates lower to boost the economy. But beginning late last year, the Fed began reducing its purchases by $10 billion a month.

Investors, however, have more than taken up the slack left by the Fed.Robust investor demand for bonds in part stems from the developed world's aging populations, who are increasingly hungry for interest income and relative safety of principal, analysts say. The long-term drag on the global economy and on interest rates from graying demographics is a favored theme of Jeffrey Gundlach, who oversees $50 billion at DoubleLine Capital in Los Angeles and who foresees a long period of subdued interest rates.

In the aftermath of the financial crisis, shell-shocked investors pumped an unprecedented net $1 trillion into U.S. bond mutual funds from 2009 through 2012, while they were net sellers of stock funds, according to the Investment Company Institute.

In 2013, bond funds saw a net outflow of $80 billion as some investors cashed out. But in the first five months of this year, the inflows resumed, totaling a net $40 billion.

Despite the potential economic and demographic downward pressure on interest rates in the next few years, those forces could easily be overridden by another: inflation. If prices for goods and services were to rise sharply and stay elevated, bond investors could quickly drive longer-term interest rates up dramatically. They would have to, or they'd risk locking in interest returns that would be badly eroded by inflation.

Since 2009, investors have had little to fear from inflation, which has remained mostly below a 2% annual rate by any of several key gauges.

Measured by the Fed's favored inflation gauge, the so-called personal consumption expenditures core deflator, annualized inflation fell to a rate of just 1.1% in January and February. That set off alarm bells that the economy could face the opposite threat: deflation, meaning a broad decline in prices fueled by dismally weak growth.

In the last few months, however, the Fed's inflation gauge has rebounded, reaching an annual rate of 1.5% in May. The better-known consumer price index also has accelerated, reaching 2.1% in May, a 19-month high (click on image below).

Asked at a June news conference whether markets should be concerned about the sudden pickup in inflation, Fed Chairwoman Janet L. Yellen said the increase was partly "noise," though she didn't elaborate. She also pointed out that, at 2%, inflation was just reaching the Fed's long-run target rate.

Still, some analysts say the surprise could be that inflation continues to rise this year, in part because of pressure from higher energy costs. "We think you'll see stronger inflation readings in the near term," said Rick Rieder, co-head of Americas fixed income at money manager BlackRock Inc. in New York.The result, he said, may be that the Fed moves to raise short-term rates "sooner than many market watchers expect."

But in the longer term, many big investors see inflation remaining low for one overarching reason: "To see a pickup in inflation you have to see it in wages. It just isn't there," said Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch in New York.

Growth in average hourly earnings of U.S. workers has crashed from an annual rate of 3% to 3.5% before the Great Recession to around 2% since 2009, Bureau of Labor Statistics data show. That's a function of continuing high U.S. unemployment and the glut of labor overseas. Many workers have no ability to press for significant wage increases.

Even though the U.S. economy added a net 288,000 jobs in June — exceeding expectations — annualized wage growth held at 2%. Historically, it has taken rising wages to fuel a sustained increase in prices — because otherwise, hefty price hikes can't stick. "To get a wage-price spiral, you'd need to have a different global economic landscape," said Prudential's Tipp.

Guggenheim's Minerd agrees that the world economy is unlikely to face entrenched inflation any time soon. But if central banks eventually get the stronger economy they're aiming for with the tidal wave of money they've unleashed since 2008, higher prices should follow, he said.

"Inflation isn't a problem for this decade," he said. "But it will be a problem for the next decade."

And emerging markets aren't exactly booming. If you don't believe me, take a look at the performance of some stock market sectors that are intrinsically tied to emerging markets. Coal, iron ore are getting killed and while there may be idiosyncratic reasons as to why, materials in general are very weak.

Any tapering in the Fed’s $85 billion-a-month asset-purchasing program
will hurt economies in Europe and Asia, where the focus remains on loose
monetary policy, Stephen L. Jen and Joana Freire of London-based hedge
fund SLJ Macro Partners LLP wrote in a June 10 report.
This decoupling would particularly strike emerging markets, which
previously served as magnets for capital as the Fed kept monetary
policy looser than their central banks did.

Now think about what will happen if we get a crisis in emerging markets
because the Fed starts tapering. It will only reinforce global
deflationary headwinds, which is exactly the opposite of what the Fed and other central banks want.

For this and other reasons I've outlined above, I just do not see the
Fed tapering any time soon. If they do, they will spark another global
financial crisis at a time when the world is still dealing with the
effects of the last crisis. Moreover, the spectre of deflation lingers,
posing a real threat to the global financial system and to pensions preparing for inflation.

As far as tapering, maybe the Fed took a look at the work of Frances Coppola and decided that QE wasn't stoking inflation expectations, it was actually pushing them down. So they decided to begin tapering hoping inflation expectations will rise. But if rates begin rising too fast, debt-laden consumers will be crushed, virtually ensuring a viral bout of debt deflation.

This is the big conundrum that people fail to realize. A rise in interest rates will benefit pension plans (discount rate rises, lowering the net present value of liabilities) and savers but it will crush many debt-laden consumers and businesses struggling to stay afloat and will lead to a full-blown emerging markets crisis, which is very deflationary.

So why is the Fed tapering? Because it sees a tepid but sustained recovery in the U.S. labor market, allowing it to rein in its asset purchasing program. More importantly, it is worried about asset bubbles which tend to benefit the 1% but not the 99% who have little or no investments in the stock market.

I also think the Fed is passing the baton to other central banks, namely the ECB, and asking them to crank up their quantitative easing. This would be bullish for the U.S. dollar and it will help bolster the performance of hard-hit global macro hedge funds staging a nascent recovery.

But as explained above, even if the Fed starts raising rates, there is too much debt and too much slack in the labor market to see a sustained rise in interest rates. Bond bears will disagree with me but they will be proven wrong.

I'll tell you who else will be proven wrong. All those equity bears waiting for a huge correction. Everyone is nervous but I stick with my outlook 2014 and view the big unwind in Q1 as another buying opportunity. I still like biotechs (IBB and XBI), small caps (IWM), technology (QQQ) and internet shares (FDN).

I would use any correction in these high beta sectors to add to my positions. In contrast, I would also be shorting the hell out of utilities (XLU) as they keep surging on investors' fears (although sustained low rates are bullish for high yielding defensive stocks).

Below, as stock indexes hit record highs, investors face a difficult choice: Do they keep betting as heavily on the markets, or do they move more money into cash? Eric Cinnamond, Aston/River Road Independent Value Fund vice president and portfolio manager, joins MoneyBeat's Steve Russolillo to discuss his views:

“There’s always a lot of pressure, especially at peaks, to get fully invested,” he said. “That’s what I think is the problem with our industry. We’re so short-sighted at times. When prices are high, the pressure to buy is the greatest. It really should be the opposite.”

Mr. Cinnamond isn’t predicting an imminent pullback. He said he doesn’t have a current market outlook and stocks “could easily keep going higher and higher.”

“The pressure to get invested is constant, but we’re very disciplined in our valuation process,” he said. “It’s just impossible for us to justify these prices.”

He's right but as Keynes noted long ago, "markets can stay irrational longer than you can stay solvent." There is a lot of liquidity and debt in the global financial system, which is why you're seeing the return of subprime debt and soaring stock and credit markets.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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